This copy is for your personal, non-commercial use only. To order presentation-ready copies for distribution to your colleagues, clients or customers, click the "Reprints" link at the bottom of any article.

Michael Finke: Is the 4% Rule Folly?

A staple of retirement income planning leaves key risks and tradeoffs unaddressed.

Somewhere along the line, the shortfall methodology that underlies the 4% rule was anointed the gold standard for judging withdrawal rate strategies. What began as a good-faith exercise to point out the risks from withdrawing too much each year from a retirement portfolio has gained a mythic and potentially unhelpful place among advisors. It’s time to dust off the 4% rule and see whether it deserves its place on the shelf of best practices.

First a mea culpa. My co-authors David Blanchett, Wade Pfau and I recently pointed out that low bond yields may nuke the 4% rule. We used the same shortfall methodology, but we ran a Monte Carlo analysis since we don’t have historical bond rates as low as the current real bond rates. So I’ve used the shortfall methodology in my own research. We can possibly be forgiven since we did it to point out one flaw of the shortfall methodology—that it only uses healthy 20th-century U.S.bond and equity returns that may not be relevant in the 21st century.

We wanted to make the point that today’s forward-looking bond rates imply no positive real yields for more than 10 years (according to TIPS rates). Since we’ve never experienced a sustained period of negative real bond yields, we might get a false sense of security from using historical bond returns in our safe withdrawal rate analyses. And current bond yields have historically predicted future 10-year bond returns with a 90% coefficient of variation (R-squared).

Add to that the importance of the first decade in retirement on portfolio failure rate, known as sequence of return risk, and relying on the safety of a 4% rule starts to look like a sucker’s bet. We estimate a failure rate beyond 50% if real yields don’t revert to their historical mean, and a 20% failure rate if yields mean revert after just five years. Unfortunately, there’s no evidence that bond rates have mean-reverted predictably in the past.

The most sobering conclusion is that retirees who believed a 4% withdrawal rate was safe in the past should instead rely on a much lower rate—perhaps as low as 2.8%—to achieve the same degree of shortfall security. Such a low rate suggests that workers need to save a lot more and retirees should cut back sharply on their lifestyle to avoid the risk of running out of money. But it doesn’t have to be that way. That’s because there’s something else wrong with shortfall studies.

Longevity Risk

Running out of money is usually at the top of the list of concerns when building a retirement income plan. It should be. The traditional shortfall methodology assumes you spend down your assets without a safety net. What happens when the trapeze artist performs without a safety net? Obviously, they’re going to be more cautious and a lot less fun to watch. You can think the same way about a retirement income plan without a longevity hedge. If you bear that risk, you’re going to be a lot more careful. And careful does not a fun retirement make.

Bearing longevity risk without a hedge is stupid. Many advisors would recoil at the idea of investing a retirement portfolio in the stocks and bonds of one company. The reason? Excessive unsystematic risk means that you get no expected reward for the amount of risk taken. These same advisors, however, don’t think twice about building a retirement portfolio without a longevity risk hedge even though the client gets no reward for the amount of longevity risk they assume.

In order to avoid this risk, advisors employ an extremely conservative retirement income strategy. Or at least it was conservative before asset yields sank to unprecedented lows. The flip side of the conservative strategy is that the retiree leaves money on the table by not enjoying retirement.

Ideally, retirees would decide how much they wanted to leave to charity and heirs, divide the remaining assets by their expected longevity, and live it up. But since their actual longevity is in the hands of the normal distribution, they spend a lot less so they have a 95% or more chance of dying with money in the bank. That money in the bank over and above their desired legacy is the money left on the table in the game of retirement living.

I asked David Blanchett, head of retirement research for Morningstar Investment Management, to estimate a traditional retirement income shortfall analysis using historical returns. We then plotted the distribution of residual wealth left over after the demise of the hypothetical client who begins with a million dollars in retirement saving and invests 50% of a portfolio in stocks, 40% in bonds, and 10% in cash. We added a 1% asset management fee. (See graph.)

Think of the $0 line as representing the point where the retiree wins the game of retirement living (assuming he or she has taken care of desired legacy through life insurance). Anything to the left means that the client ran out of money before the finish line. Anything to the right means money was left on the table: vacations not taken, restaurants not visited, flights to visit family not flown. Those with a more puritan ethic might view this as not such a bad thing, since it represents a legacy for the next generation. But wouldn’t it be better to decide how much legacy is optimal and spend the remainder on the best possible lifestyle in retirement? That is why we save money in the first place.

The problem with the shortfall analysis is that it cares only about the outcomes to the left of the line. When you’re on the trapeze without a safety net, it makes sense to care most about not falling and less about a more entertaining performance. What if there was a different objective? What if the objective was happiness? Would that change how we spend money in retirement? Yes, say most economists. The 4% rule ignores the outcomes to the right of the line. If we took those more positive outcomes into account then we’d behave differently.

Better Approaches

More rigorous academic studies give us a much clearer idea of how to win the retirement living game. The first rule of retirement income planning is that every competitively priced tool has tradeoffs. There is no retirement product alchemy; putting investments in buckets, wrapping them in a variable annuity, exposing them to greater market risk, putting all your money in TIPS—each has its own pluses and minuses. The right plan mixes the tools to best achieve retirement objectives.

A 2008 study by Olivia Mitchell from Wharton and her co-authors from Goethe University in Frankfurt shows the amount of welfare gained and lost from a number of different retirement income strategies. As with similar articles by Moshe Milevsky and an article I published last year with graduate student Duncan Williams and American College professor Wade Pfau, an important element of the optimal retirement strategy is risk tolerance. More risk-averse retirees will prefer strategies that avoid the possibility of a steep drop in spending.

The tradeoff of annuitization is reduced liquidity available to meet unexpected expenses, such as a decline in health and a lower bequest amount. But wrapping any investment in an annuity, whether it be the safe bond portion of a portfolio using a SPIA or risky assets in a variable annuity, provides greater annual spending and a safety net that protects against a severe drop in spending if investment assets run out in old age. It is important to note that expenses embedded within each of these options will impact optimal strategies.

So what is the right plan? The answer is that it depends on clients’ risk aversion (and assessing risk aversion isn’t easy) and how much happiness they get from spending their own money versus passing it on to their heirs. The optimal plan for risk-averse retirees leans toward full annuitization. For more risk-tolerant retirees or retirees with a stronger bequest motive, the best option is to annuitize later in life (or buy a deferred annuity). It should be noted that Moshe Milevsky has been making this point for over a decade.

Mitchell and her co-authors estimate that the average retiree could improve expected happiness in retirement by as much as 50% by employing a blended annuitization and investment strategy. They also find that one of the best ways to improve welfare isn’t through just annuitization but flexibility in withdrawal rates. This is the last problem with the 4% strategy: It doesn’t allow retirees to ratchet down spending if they experience bad luck in their investments or increase spending if they do well. This lack of flexibility both increases the likelihood that they’ll run out of money when faced with low investment returns, and leaves more money on the table if markets perform well.

One example of a dynamic strategy forced upon retirees is required minimum distributions. Unfortunately, the U.S.tax code does not encourage retirees to build a safety net through annuitization within qualified accounts. Both the U.K. and Germany provide strong incentives to annuitize in advanced age.

So what should we make of a 4% rule that is based on a process that fails to hedge longevity risk, may be overly conservative and spends a fixed amount each year regardless of investment experience? We should recognize that this approach was useful in beginning the conversation about optimal withdrawal rate strategies, but science is all about constantly improving on old techniques. Best practices mean changing with the times.